Tom Sharbaugh ()
It was hard to miss the widespread news coverage of the new crowdfunding provisions in the Jumpstart Our Business Startups Act of 2012, which is more commonly referred to as the JOBS Act. Title III of the act exempted certain crowdfundings from the registration requirements of the federal securities laws, and the U.S. Securities and Exchange Commission issued proposed regulations in October 2013 to implement the exemption. The proposed crowdfunding regulations received many comments, often related to the prohibitive cost of the proposed requirements, and the SEC still has not issued its final rules. Many states have filled the void by adopting their own crowdfunding exemptions, often citing job creation as the goal. However, neither the Pennsylvania legislature nor the Pennsylvania Securities Commission has joined this trend.
The states do not have the power to override the SEC, but there is a longstanding federal exemption from registration for intrastate offerings under Section 3(a)(11) of the Securities Act of 1933, as amended, and its safe harbor means of compliance, Rule 147. Many states have structured new crowdfunding exemptions to work along with the federal intrastate exemption. The state exemptions generally eliminate certain of the provisions of the proposed crowdfunding regulations that have drawn the most fire, including the requirements to use a broker-dealer or funding portal in an offering of any size, prepare audited financial statements for offerings of more than $500,000 and distribute periodic financial reports to investors after the offering.
Small companies have not used the federal intrastate offering much because it is generally easier to comply with other exemptions, such as those provided by Regulation D. However, the intrastate offering does provide an opening for more lenient crowdfunding exemptions at the state level. The federal intrastate exemption has a number of unusual requirements, most notably that the issuer be organized and do a substantial amount of business in the chosen state, and that the issuer offer and sell securities only to residents of that state. However, because much of crowdfunding is inherently local in nature, these requirements are not insurmountable, although the intrastate exemption may reduce the number of companies that are formed in Delaware, almost by default.
Kansas and Georgia were the first states out of the gate with their Invest Kansas Exemption and Invest Georgia Exemption, respectively. The additional states that have intrastate exemptions from registration, as the result of legislative or regulatory action, include Alabama, Indiana, Michigan, Washington and Wisconsin. In addition, legislative action for a crowdfunding exemption is pending in Florida, New Jersey and North Carolina.
Like the federal crowdfunding exemption, most of the new state exemptions cap the size of the offering at $1 million. However, certain of the states increase the cap to $2 million if the issuer has audited financial statements (including Indiana, Michigan, North Carolina and Wisconsin). The proposed New Jersey exemption has a cap of $1 million, but it excludes the amount sold to any accredited investor (generally, a natural person with annual income of more than $200,000 or a net worth of more than $1 million).
All of the state exemptions follow the federal principle of limiting the amount that may be invested by an individual investor. Under the federal crowdfunding exemption, the limitation on investment during a 12-month period depends on the financial status of the investor: the greater of $2,000 or 5 percent of annual income or net worth, if the annual income or net worth of the investor is less than $100,000; and 10 percent of annual income or net worth (not to exceed an investment of $100,000), if the annual income or net worth of the investor is at least $100,000.
The state exemptions have individual investment limitations ranging from $1,000 for Kansas to $10,000 for Georgia, Michigan and Wisconsin, irrespective of the income or net worth of the investor (except for the Washington exemption). Moreover, whereas no investor can invest more than $100,000 under the federal crowdfunding exemption, the state exemptions generally permit an accredited investor to invest an unlimited amount.
The pending New Jersey bill presents the closest geographic competition to Pennsylvania at this time. Under SB 712, an issuer may raise up to $1 million excluding investments by accredited investors, and each investor who is not an accredited investor may invest up to $5,000. The New Jersey bill has certain disclosure requirements, but it does not require audited financial statements.
One potential problem with the state intrastate exemptions is that a company relying upon the federal intrastate exemption from registration as well as one of the state intrastate crowdfunding exemptions may exceed the threshold for registration under Section 12(g) of the Securities Exchange Act of 1934, as amended, which triggers the expensive periodic public company reporting requirements. Section 12(g) requires registration by an issuer with more than $10 million in assets and a class of securities held by either 2,000 people, or 500 people who are not accredited investors. The federal crowdfunding exemption provides that any securities issued under that crowdfunding exemption are excluded from the Section 12(g) calculation of holders.
The SEC has not overlooked the growing number of state intrastate crowdfunding exemptions. On April 10, the SEC added three pertinent interpretations to its Compliance and Disclosure Interpretations (Questions and Answers of General Applicability). The SEC clarified that although Rule 147 does not prohibit general advertising or general solicitation, any general advertising or solicitation “must be conducted in a manner consistent with the requirement that offers made in reliance on [the federal intrastate offering exemption] be made only to persons resident within the state or territory of which the issuer is a resident.”
This obviously presents a challenge for issuers using the Internet to solicit investors. The SEC further explained that use of the Internet could be compatible with the federal exemption if “adequate measures” were taken to confirm that securities would be offered only to people resident in the relevant state.
With respect to a question concerning use of a third-party Internet portal, the SEC stated that “such measures would include, at a minimum, disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law, and limiting access to information about specific investment opportunities to persons who confirm they are residents of the relevant state (for example, by providing a representation as to residence or in-state residence information, such as a zip code or residence address).”
The SEC’s recent interpretations also cast doubt on whether an issuer could use its own website for a Rule 147 intrastate offering, because companies generally use their websites to “advertise their market presence in a broad, indiscriminate manner.”
Based on an informal inquiry to the Pennsylvania Securities Commission, there is no pending action to allow intrastate crowdfunding in Pennsylvania. Many issuers rely on Pennsylvania’s limited offering exemption for small offerings, but this exemption is inconsistent with crowdfunding due to the limitations on the numbers of offers and sales and the prohibition on general solicitation. Pennsylvania does have an exemption for offerings made in compliance with the federal intrastate exemption, but the exemption is only available if the offering is made solely to accredited investors.
It is not surprising that the PSC has neither adopted nor promoted more lenient crowdfunding. In the spring of 2012 when Congress was considering the federal crowdfunding exemption, the PSC issued specific recommendations that conflicted with the final JOBS Act. In its spring 2012 issue of The Bulletin, the PSC urged Congress to reduce federal regulation in this area and allow the states to provide “appropriate oversight,” cap the offering size at $500,000 and the individual investment amount at $1,000, and limit the number of crowdfunding offerings in which an individual could invest during a 12-month period.
The federal crowdfunding exemption preempts state law in most respects, so once the SEC finalizes the regulations for it, Pennsylvania-based companies that comply with that exemption will be able to engage in crowdfunding. However, they will not be able to take advantage of the cheaper and quicker intrastate crowdfunding exemptions that will be available in many other states.
The PSC no doubt has the best intentions—protecting investors from investments in small companies that are typically risky and illiquid. However, regulators need to balance their goal of protecting investors against the risk of stifling business growth. A Georgia pro-business group has already publicly invited Ohio entrepreneurs to move south, where the capital-raising climate is friendlier. Many commentators believe that it will be too costly for entrepreneurs to use the federal crowdfunding exemption. In response to these concerns, many states have constructed a reasonable alternative—an exemption that lacks certain expensive protections of the federal exemption, but still limits the amount that individuals other than accredited investors could lose. Pennsylvania should do the same—even if it just adopts the very restrictive guidelines that the PSC recommended to Congress in 2012.
It will be impossible to determine empirically whether the federal and state regulators struck the right balance between investor protection and efficient capital-raising. Time will tell whether Pennsylvania’s lack of an intrastate crowdfunding exemption will make the state less attractive to startups than other states.
Tom Sharbaugh is a partner in the business and finance practice group of Morgan, Lewis & Bockius, resident in the Philadelphia office.